We’ve been spoiled with cheap debt ever since the global financial crisis ended in 2009. Cheap debt is money that banks lend out for essentially little to no cost because the government keeps interest rate so low. Therefore, the cost of debt to consumers and investors is low as well.
It’s one of the most dangerous forms of finance. Debt. Using money that you don’t have to finance your purchases and/or investments. It’s especially risky if you use loans, margin, and debt to finance your investments. Investments, even sound ones, carry a significant amount of risk.
In 2021, there was an abundance of cheap liquidity and debt in the markets. Interest rates were near zero and people were using that debt to buy real estate at a record pace. The Federal Reserve made it very easy to access cheap credit.
I was actually one of them who took advantage of low interest rates and cheap debt. I took on 0% credit 1-year debt that came with an upfront 3% fee. With inflation at multi-decade highs at 8%+, I thought it was worth it to take on the debt. My interest rates were lower than inflation!
Although I haven’t used the debt for any purpose, I can confirm that it is not worth it to use leverage and debt. Many people have gotten very rich of them. However, even more people have gotten poor because of them. Accessing cheap credit is not the wisest financial move.
Cheap Debt: What is it?
Cheap debt is money that the bank lends out for low interest rates. Low interest rates range anywhere between 1.75% – 4.5%. Anything higher than that and the cost of capital and the cost of money is actually pretty expensive.
The government encourages cheap capital so more people use it to prop up the economy. They know some people will fail and declare bankruptcy as a result. However, as long as the net result of people accessing cheap credit is a positive one, they know they’re doing the right thing.
It’s a double edged sword. People get enamored because, well, a 3% interest rate is almost free money. However, that doesn’t come without risks. There’s a reason why Dell came out ahead in the computer market out of the dot com bust relatively unscathed.
Many competitors were bigger than Dell. However, Dell came out ahead of them because its competitors declared bankruptcy because of cheap debt. Dell had no debt on their balance sheet at the time. Therefore, when the market turned sour, they survived the poor conditions.
They even took advantage of the market since their competitors were out of the picture. The people who took on low interest debt during 2020 – 2021 felt the most pain in 2022 and beyond. It sounds good in theory. But it’s quite dangerous and you’re playing with fire.
The fire will not be kind to you when the market turns sour.
Cheap Debt: Should You Take It?
With every other question in personal finance, the answer is, it depends. What does it depend on? The factors are listed as below.
1) Cheap Debt: What is the Purpose?
What is the cheap debt used for? Is it used for real estate investing? Is it used to buy stocks on margin? In general, using debt for real estate investing purposes is a good thing. As long as the numbers work. Bonus points if you have a reserve fund to keep you afloat throughout the times.
The purpose of the debt matters in this case. There are many people who use cheap debt… to purchase a boat. What?! Not to purchase a boat for commercial reasons. But to purchase a boat because they’ve always wanted to buy a boat.
It has no return of capital and the boat is a depreciating asset that they only use twice a year, anyway. That’s just not the right purpose to take on debt at all. Debt should be used to at least pay you back more money later down the road.
Not to spend it 100% on a depreciating asset that has no return on capital. That is not a smart allocation and use of capital
2) What Kind of Cheap Debt is it?
Is the cheap debt floating or fixed interest rate? When does it mature? Is it amortizing debt? The terms of the debt matters when you’re considering what your goals and lifestyle choices are. You don’t want to take on floating rate debt in a rising interest rate environment.
Especially when you really wanted fixed rate debt. You don’t want to take on debt that matures in 1 year if you were expecting to take on a 5-year debt. Many people just sign on the dotted line without thinking of what kind of debt that they want.
It’s even worse when people take on payday loans. The most evil type of loan in the world. How these loans are legal is completely beyond my comprehension and understanding. Payday loans are one of the worst money traps to fall into.
Once you sign a legally binding and enforceable contract, it’s quite difficult, if not impossible, to get out of it. You need to have a deep understanding of what you’re getting yourself into.
3) Can You Psychologically Withstand Having Debt?
The psychological aspect of having debt on your balance sheet makes a huge difference. I personally found out that I cannot absolutely stand having debt on the balance sheet for that reason. It makes me feel so uneasy and unsure just having that debt on my books.
Even if I make monthly payments and know that I’m paying down the debt every month. Having that hanging over my head just isn’t worth it for me, no matter how cheap the debt is. I took on $35k 5% 3-year amortizing debt back in 2021. I had to pay it off in just 6 months because it was so bad.
The cheap debt is expensive when it comes to measuring in mental anxiety terms. The peace of mind of not owing anything to anybody in the world feels amazing. It makes you feel like you own your entire life outright.
You don’t want someone hanging money over your head to control you. It’s the worst feeling in the world.
4) Can You Afford the Interest Payments?
Real estate investors don’t buy the purchase price. They buy the monthly payments that comes with the principal, interest, taxes, and insurance payments of the house. If you can afford the monthly interest payments, then it may not be a bad idea to take on the cheap debt.
I personally don’t want to take on debt even if I can afford the interest payments. There’s a reason why so many billionaires advise against starting a business on a loan. You’re not just playing with fire that can burn you. You’re playing with fire that can permanently ruin your life.
However, if you still want to go through with taking on debt, against my advice, then you have run the numbers to see if you can afford the interest payments. Interest payments aren’t going to be expensive because it’s low interest rate debt.
However, that doesn’t mean that it’s still not going to be significant. Don’t forget the principal that will be due by the end, either.
5) Will The Cheap Debt Set You For Ruin if Things Go Wrong?
When I took on the cheap debt, it was about $35,000 of 5% debt on a 3-year term. If I lost my job tomorrow, I had enough ample liquidity and reserves on hand to pay all that off, and then some if things went wrong. That’s how I knew I could afford the debt.
I had a net worth of $400,000 at the time so my debt to equity would be very manageable at under 10%. So by all mathematical standards, I could afford the debt. In any way that you wanted to slice it. That’s why I thought it was a sound idea to take on the debt.
Maybe even use the debt to bring me more money later down the road. Even though it didn’t quite exactly work out like that, having the debt on my books wouldn’t have put me into ruin in any way whatsoever. It felt weird having that much cash on hand but I still went through with it.
If the debt has a chance to ruin you, it’s not a good idea to take it on.
6) Is Every Other Part of Your Finances Taken Care Of?
It’s one thing to be able to afford cheap debt, but if other parts of your personal finance isn’t taken care of, then it’s not a good idea. Examples include paying off any high interest rate debt such as credit card loans. Refinancing the credit card debt with the lower interest rate is completely fine. Otherwise, it’s bad.
Americans are saving money as a record low pace as of November 2022.
And they are taking on debt at the highest pace as of November 2022 as the credit card balances reached record highs then. When you’re taking on debt, the other aspects of your finances cannot have cracks in it. You cannot be wondering if you can pay off your mortgage or rent for the month.
That’s just putting yourself up for failure. Your other parts of your finances should be taken care of if you’re thinking of taking on the risk of debt. Debt is not as risk-free as the guru investors make it out to be. Debt is full of risk that investors have to be aware of.
You do not want to take on additional risk if all other aspect of your risk isn’t already taken care of.
7) Have You Been Through a Bear Market?
Many investors lost their shirts in the 2022 onslaught of the bear market. If you’ve been through at least a single cycle of the bear market, then that’s good news. However, if you haven’t, then it’s not a wise idea to take on cheap debt, especially if you want to invest it.
Many real estate investors will not be able to sell their homes as mortgage rates approach 10%. 7% mortgage used to be the norm decades ago but housing prices weren’t as high as it is today. A bear market is the ultimate test whether or not you can manage the risk throughout the storm.
The storm is wild. People think we can’t experience a once in a lifetime bear market and recession until they happen. There’s going to be many once in a lifetime events you experience throughout your life. It’s better to be prepared for them instead of the other way around.
Preparing for the worst and have the best happen is a great strategy.
8) Is the Debt Necessary?
There are people who take on debt without having any sort of purpose in mind. They just want to take on the debt because they want to feel having that cash on hand on their balance sheet. Is the cheap debt necessary? Can you survive and live just as happily without it?
If the answer is yes, you can survive without it, then it doesn’t make sense to take on any amount of debt at all. Why complicate your good life even further? There’s other things you can accomplish in the meantime. If you can simplify your life instead of complicate it, why not simplify?
The older you get, the more you value simplicity. You don’t care about maximizing returns, all you care about is keeping your life as simple as possible. Unnecessary cheap debt is one of the worst debt you can have on your balance sheet.
Your life should be getting better as time passes, not worse.
9) Are You Overpaying for the Debt?
Companies don’t reward loyalty. Companies take advantage of loyalty. Banks will offer you a worse rate than normal even if you are a long time and valued customer. Some customers with an established relationship with a bank offer worse terms than to a complete stranger.
They know the customer will agree, anyway.
As credit cards stay in the market for years, banks offer lucrative sign up bonuses to new customers, depending on profitability. The early adopters of the credit card do not get lucrative terms as the late adopters. If you’re wondering whether the cheap debt is worth it, ask yourself.
Is your bank offering favorable terms even though you’ve been a long time client? In 2023, anything above a 6% interest rate debt is not the right debt. I took on 3% 1-year maturing interest rate debt for $15k in 2022.
Although the times of cheap debt may be nearing its end, that still doesn’t mean you should overpay. Even mortgages aren’t cheap debt these days. We’re even better off buying a house in cash.
Beware of Cheap Debt: It’s More Expensive Than You Think
The cost of cheap debt isn’t just the interest rate that you pay. The cost of the debt is the psychological burden and aspect of knowing you even have that burden in the first place. I’ve done it and from experience, I can confirm. It’s not worth it.
If I ever have the chance to take on cheap debt that isn’t a mortgage, then I’m not going to take it. I used to be in the “if the debt makes you more money than what you’re paying for it, then it’s worth it” crowd. Not anymore. Debt isn’t worth it by any means.
Yes, you shouldn’t be paying off your mortgage early if you have a 3% mortgage. However, when that burden is lifted off your shoulders and you pay off the house for the first time? That’s worth more than any amount of money that you can think of.
There’s a reason why big companies spawn out of recessions. It isn’t because they took on a large amount of debt. It’s because those companies had minimal debt and could afford to buy as many companies as they could for 10 cents on the dollar when their competition got wiped out.
On the consumer side, it’s worrying that credit card debt is so high.
Cheap debt is the most expensive debt. The interest rate is one thing. But the additional risk that you didn’t have to take on is another. An extra $10,000 worth of debt in your books holds an additional $100,000 worth of risk, in my mind.
No matter how low the interest rate actually is.
Cheap Debt: Should You Take It?
- Cheap debt: what is the purpose?
- What kind of cheap debt is it?
- Can you psychologically withstand having debt?
- Can you afford the interest payments?
- Will the cheap debt set you for ruin if things go wrong?
- Is every other part of your finances taken care of?
- Have you been through a bear market?
- Is the debt necessary?
- Are you overpaying for the debt?
